What are the advantages and disadvantages of using multiples vs DCF for valuation? (2024)

FAQs

What are the advantages and disadvantages of using multiples vs DCF for valuation? ›

DCF has several advantages over multiples. First, DCF is based on the intrinsic value of the company or asset, rather than on the market price or the performance of peers. Second, DCF allows for more flexibility and customization, as it can incorporate different scenarios, assumptions, and sensitivities.

Many finance professionals use both methods to triangulate a range of values for a company. While DCF might give an intrinsic value, Multiples can provide a market-relative perspective. Using both can offer a more holistic view of a company's valuation.

The disadvantages of using multiples are that they can be misleading, inconsistent, and subjective. You may not find truly comparable companies, or you may have to adjust for different accounting practices, growth rates, risk profiles, and capital structures.

Using multiples in valuation analysis helps analysts make sound estimates when valuing companies. This is especially true when multiples are used appropriately because they provide valuable information about a company's financial status.

Final answer: DCF valuation, also known as discounted cash flow valuation, is a technique used in finance to determine the value of an investment. It has advantages such as providing an opportunity to learn about a business and being one of the soundest valuation techniques.

DCF Valuation truly captures the underlying fundamental drivers of a business (cost of equity, weighted average cost of capital, growth rate, re-investment rate, etc.). Consequently, this comes closest to estimating intrinsic value of the asset/business. Unlike other valuations, DCF relies on Free Cash Flows.

Discounted cash flow uses a discount rate to determine whether the future cash flows of an investment are worth investing in or whether a project is worth pursuing. The discount rate is the risk-free rate of return or the return that could be earned instead of pursuing the investment.

We do not use a DCF if the company has unstable or unpredictable cash flows (tech or bio-tech start-up) or when debt and working capital serve a fundamentally different role.

The DCF with multiple assumes the terminal value of a startup will be the realized amount of its exit, occurring at the end of the projected period. This way, fewer additional assumptions are needed on the future course of the company beyond the forecasted years.

What do valuation multiples tell you? ›

Valuation Multiples are ratios that reflects the implied value of companies in relation to a specific operating metric. Usage of a valuation multiple – a standardized financial metric – facilitates performing comps analysis among peer companies with different characteristics, most notably size.

The most common multiple used in the valuation of stocks is the price-to-earnings (P/E) multiple. Enterprise value (EV) is a popular performance metric used to calculate different types of multiples, such as the EV to earnings before interest and taxes (EBIT) multiple and the EV to sales multiple.

Why should you use a price multiple whenever possible rather than a discounted cash flows analysis? Interest rates are not considered in DCF analysis. Future interest rates cannot be calculated. DCF analyses cannot be made beyond five years.

One key difference between the comparables approach and the DCF model is that the former does not explicitly spell out the economic agents' expectations of future cash flows or discount rates. Instead, the expectations and discount rates are embedded in the observed prices of the comparable assets.

The advantages of relative valuation as a valuation technique include its ability to reflect current market conditions and rely on observable data. Relative valuation is known for being relatively simple compared to other valuation methods like discounted cash flow (DCF) analysis.

EV is an appropriate way to measure the value of the entire company rather than just the stock price, which looks only at the equity market capitalization of the stock, ignoring the company's cash, minority interests and debt. The enterprise multiple compares the total value of a company relative to its cash profits.